Tribal Group: cheap as chips

Tribal Group is a well diversified outsourcing company serving the public sector in the UK and overseas. It handles inspections for OFTSTED, housing and regeneration projects, and a whole bundle of consulting projects and services for councils and ministries. Besides the UK, it has exposure to Australia and the Middle East. Its recent interim results were robust, with revenues up 11%, and it raised the interim dividend.

So why is it sitting on a PE of 5?

One of the answers is the fact that it came a cropper in 2004 as a result of indigestion after , the group made a few too many acquisitions. It acquired nine businesses in the first two years after its flotation in 2001; many analysts believed it would build up into a rival to the gorilla of outsourcing, Capita. Like many acquisitive groups, it hadn't expended enough effort on understanding and integrating the businesses properly – and saw margins slide, with a series of profit warnings. The share price dived, and though CEO Henry Pitman survived in the short term, he stepped down in 2007.

The co's credibility has obviously suffered. A £6m net loss in 2007, as the company took a restructuring hit under new CEO Peter Martin, didn't help. At the same time, with all three major political parties advocating savage cuts in public spending, Tribal's business model doesn't look as attractive as it used to. Some of the result of tightening in public sector budgets has already been seen, with services which rely on property development – regeneration, new buildings for schools, housing associations – showing weak results.

Take a closer look though, and the company doesn't seem horribly skewed towards the worst affected areas. While education accounts for 42% of the revenue, its high margin – 13.5% last year , well above the other activities in the group – makes it the biggest contributor to profit. On the other hand support services, which include planning and regeneration, probably the most likely to suffer, accounts for only 18% of revenues – and has the lowest margin in the group, at 4.4%] [ref] Tribal Group half yearly report: http://www.tribalgroup.co.uk/Documents/Investors/Tribal%20Half%20year%20results%202009.pdf [/ref]

The interim results were reasonably robust. Sales increased by 11%, and while adjusted pre-tax fell slightly, from £9.1m to £8.5m,that was after a £800,000 restructuring cost. Management felt sufficiently confident of the full year outcome to increase the interim dividend by 10%.

That quite reasonable result came despite the admission that trading conditions have been difficult. In consulting activities, there has been pressure on fee rates, while regeneration and the Further Education capital programme in the UK suffered badly. Cost savings of an annualised £6m [ref] Tribal Group half year presentation: http://www.tribalgroup.co.uk/Documents/Investors/Half_Year_results_for_the_six_months_ended_30_June_2009_FINAL.pdf [/ref] should help the company maintain margins.

It's also worth noting the company's remarkably good visibility of earnings. Committed income grew in the first half from £139m to £217m – though the sales pipeline fell from £297m to £258m . That doesn't look too good, but the hit was entirely in education, which saw its pipeline almost halve – support services and consulting, which are the areas most at risk from recession, saw the pipeline grow quite satisfactorily. (I suspect winning the big OFSTED contract might have something to do with the fall in the education pipeline, too – that was a £75m deal.) 83% of 2009 income is already contracted [ref] Tribal Group half yearly report: http://www.tribalgroup.co.uk/Documents/Investors/Tribal%20Half%20year%20results%202009.pdf [/ref] , which is pretty good visibility.

Tribal has a strong balance sheet – gearing is only 7.8%. The company has £46m facilities, of which £40m is committed until 2012, so no need to refinance – in fact only £16m of the facility is currently used, so Tribal has flexibility if it wants to pick up competitors on the cheap. (Though as a recovering acquisitioholic, it probably shouldn't.)

Tribal seems to be doing the right things. It's diversifying geographically, with contracts in Oman and Abu Dhabi, and it's expanded its education work from the public sector to work with major employers such as Sainsburys and MacDonalds on employee training. It even has a training contract with the US Navy. Meanwhile it's targeting cost reduction programmes and procurement as growth areas for consulting.

The OFSTED contract is probably the company's most important, and as broker Collins Stewart notes, the six-year deal helps to reduce risk for the group as a whole [ref] Reuters stock news, in Forbes, 18 August 2009: http://www.forbes.com/feeds/afx/2009/08/18/afx6788508.html [/ref] .

Granted this is a company which threw away its street cred some years ago, and granted the public sector no longer looks like a cast iron guaranteed cash cow, I still can't believe Tribal is selling on 5x historic earnings, and with a nearly 5% yield. Analysts' forecasts, for what they're worth, are still showing earnings increasing over the next two years, though only by single digit percentages. The dividend is four times covered, the balance sheet doesn't look stretched, so it's difficult to see where is the inflection point that will send the company spiralling down into crisis.

The big question is probably whether the outsourcing trend has peaked. But this is a question some people were asking back in 2004 [ref] Citywire, 23 November 2004:http://www2.citywire.co.uk/adviser/-/news/market-and-shares/content.aspx?ID=261978&Page=2 [/ref] , and it certainly doesn't seem to have happened to judge by results from Tribal's competitors Serco and Capita. While PFI may get hurt, fewer new PFI contracts would hurt the construction sector much harder than it would hurt Tribal. And it's hard to see any government, whether right or left wing, taking contracted-out public services in-house again, with all the cost that would involve. Indeed, a recent report in the Guardian [ref] Guardian, 16 September 2009: http://www.guardian.co.uk/business/2009/sep/16/public-spending-winners [/ref] suggested that companies like Serco, Capita, and Compass catering could win more business as local councils outsource to save money. Bob Scott, VP Public sector outsourcing at consultant Capgemini, believes that 'first generation' outsourcing hasn't gone very far – most police services, for instance, only outsource simple discrete services such as cleaning. He feels there's still room for many quangos and government bodies to outsource further services – before 'second generation' outsourcing, which actually changes the processes and procedures, can be thought about [ref] Computing, 24 September 2009: http://www.computing.co.uk/computing/analysis/2250023/government-4826275 [/ref] .

There may also be more opportunities for outsourcing in the private sector as companies 'stick to their knitting' and outsource such activities as field engineering support, maintenance, and facilities management – Tribal's education division activities with major private sector employers suggest it has already identified an opportunity here.

Tribal's 5x valuation is less than half the sector's 11x historic multiple. But if you compare the stock to its larger rivals Serco Group and Capita Group, its valuation looks even more out of kilter.

Serco Group is a bit more blue collar in many of its operations than Triball it has a particular speciality in transport systems, running the Docklands Light Railway and some air traffic services. Its track record is one of unblemished growth – the last five years have seen steady increases in earnings, and that's forecast to continue. A record number of contract wins helped the company increase its earnings by a third in the first half of the year [ref] The Independent, 27 August 2009: http://www.independent.co.uk/news/business/news/record-contract-wins-see-serco-profits-up-a-third-1777719.html [/ref] .

So perhaps we shouldn't be surprised that Serco Group is trading on 23x historic earnings, and pays a derisory 1% yield. That's a lot of clear blue sea between £SRP's valuation and Tribal's.

Capita Group has a similar excellent earnings record, and a similarly high PER of 22x. Its yield at 2% is a bit more interesting, but there's not that much to choose between the two sector leaders.

Sponsored research house Edison Investment Research sees Tribal as a cheap stock. It's forecasting EPS to increase from 14.7p to 15.4p this year – only 5%, which is quite a way behind Serco Group and Capita Group . But Edison's analyst points to the fact that many of Tribal's contracts are targeted on cost savings and value for money – so tighter public spending could play into the company's hands. High levels of committed income and good earnings visibility should also help the group weather the storm [ref] Growth Company Investor, 4 August 2009: http://www.growthcompany.co.uk/features/1063952/brokers-views-edison-investment-research.thtml [/ref] .

I really hesitate to recommend this stock. I've been bitten too many times by shares that look cheap as chips – and end up with huge losses, massive debts, and a share price about a tenth of what I paid for it. But having looked at the downside that exists with Tribal, I still feel it doesn't justify the low rating – the undervaluation is just too extreme.

DISCLOSURE: Yes, I've got some in my ISA.